Internal Revenue Bulletin:
2011-49

December 5, 2011

Rev. Rul. 2011-28

Substitution of insurance policy. This ruling provides guidance regarding whether a grantor’s
retention of a power, exercisable in a nonfiduciary capacity, to acquire
an insurance policy held by a trust by substituting other assets of
equivalent value will cause the value of the insurance policy to be
includible in the grantor’s gross estate under section 2042
of the Code. The ruling provides that a grantor’s retention
of the power, exercisable in a nonfiduciary capacity, to acquire an
insurance policy held in trust by substituting other assets of equivalent
value will not, by itself, cause the value of the insurance policy
to be includible in the grantor’s gross estate under section
2042, provided the trustee has a fiduciary obligation (under local
law or the trust instrument) to ensure the grantor’s compliance
with the terms of this power by satisfying itself that the properties
acquired and substituted by the grantor are in fact of equivalent
value, and further provided that the substitution power cannot be
exercised in a manner that can shift benefits among the trust beneficiaries.

ISSUE

Whether a grantor’s retention of the power, exercisable
in a nonfiduciary capacity, to acquire an insurance policy held by
a trust by substituting other assets of equivalent value will cause
the value of the insurance policy to be includible in the grantor’s
gross estate under § 2042 of the Internal Revenue Code.

FACTS

D, a United States citizen, established
and funded Trust with cash. Thereafter, Trust purchased a life insurance
policy on D’s life. Trust is an irrevocable
trust for the benefit of D’s descendants.
T is the trustee of Trust, and the terms of
Trust prohibit D from serving as trustee of Trust.
D makes gifts every year to Trust, and Trust
pays the premium on the insurance policy. The proceeds of the policy
are payable to Trust upon D’s death.

D cannot revoke, alter, amend, or terminate
the trust. The governing instrument of Trust, however, provides D with the power, exercisable at any time, to acquire
any property held in Trust by substituting other property of equivalent
value. The trust instrument provides that the power is exercisable
by D in a nonfiduciary capacity, without the
approval or consent of any person acting in a fiduciary capacity.
To exercise the power of substitution, D must
certify in writing that the substituted property and the Trust property
for which it is substituted are of equivalent value. In addition,
under local law, T has a fiduciary obligation
to ensure that the property that D seeks to substitute
is equivalent in value to the property distributed to D. Moreover, if a trust has two or more beneficiaries, local law
requires the trustee to act impartially in investing and managing
the trust assets, taking into account any differing interests of the
beneficiaries. Finally, under local law and without restriction in
the trust instrument, T has the discretionary
power to acquire, invest, reinvest, exchange, sell, convey, control,
divide, partition, and manage the trust property in accordance with
the standards provided by law.

D has no incidents of ownership in the insurance policy unless
D’s right of substitution is considered an incident of ownership.
D dies without having exercised the power to
substitute with respect to the life insurance policy.

LAW AND ANALYSIS

Section 2042(2) provides that the value of the gross estate
includes the value of all property to the extent of the amount receivable
as insurance under policies on the life of the decedent by beneficiaries
(other than the executor), with respect to which the decedent possessed
at decedent’s date of death any of the incidents of ownership
in the policies, exercisable either alone or in conjunction with any
other person.

Section 20.2042-1(c)(2) of the Estate Tax Regulations provides
that the meaning of the term “incidents of ownership”
is not confined to ownership of the policy in the technical legal
sense. Generally speaking, the term refers to the right of the insured
or the insured’s estate to the economic benefits of the policy.
Thus, the term includes without limitation the power to change the
beneficiary, to surrender or cancel the policy, to assign the policy,
to revoke an assignment, to pledge the policy for a loan, or to obtain
from the insurer a loan against the surrender value of the policy.

Section 20.2042-1(c)(4) provides that a decedent is considered
to have an incident of ownership in a policy held in trust if, under
the terms of the policy, the decedent (either alone or in conjunction
with another person) has the power (as trustee or otherwise) to change
the beneficial ownership in the policy or its proceeds, or the time
or manner of enjoyment thereof, even though the decedent has no beneficial
interest in the trust. Moreover, assuming the decedent created the
trust, such a power may result in the inclusion in the decedent’s
gross estate under § 2036 or 2038 of other property transferred
by the decedent to the trust if, for example, the decedent has the
power to surrender the insurance policy and if the income otherwise
used to pay premiums on the policy would become currently payable
to a beneficiary of the trust in the event that the policy were surrendered.

In Rev. Rul. 84-179, 1984-2 C.B. 195, the decedent purchased
an insurance policy on his life and transferred all incidents of ownership
to his spouse. His spouse designated their adult child as the policy
beneficiary. Subsequently, the spouse died and her will established
a residuary trust for the benefit of the child. The decedent was
designated the trustee of this trust. The insurance policy on the
decedent’s life, which was part of the residuary estate, passed
to the testamentary trust. As trustee, the decedent had broad discretionary
powers in the management of the trust property and the power to distribute
or accumulate income. Under the terms of the policy, the owner could
elect to have the proceeds made payable according to various plans,
use the loan value to pay the premiums, borrow on the policy, assign
or pledge the policy, and elect to receive annual dividends. The
will did not preclude the decedent from exercising these powers, although
the decedent could not do so for his own benefit. The decedent paid
the premiums on the policy out of other trust property and was still
serving as trustee when he died.

Citing the legislative history of § 2042(2), the ruling
states that Congress intended § 2042 to parallel the statutory
scheme governing those powers that would cause other types of property
to be included in a decedent’s estate under §§ 2036
and 2038. Section 2036 applies to the transfer of property where
rights or powers are retained incident to the transfer, and § 2038
pertains to situations where property is transferred and power over
the property subsequently returns to the transferor-decedent.

Under the facts in Rev. Rul. 84-179, the decedent transferred
the policy to his wife and subsequently, in an unrelated transaction,
reacquired incidents of ownership over the policy in a fiduciary capacity.
The ruling holds that the decedent will not be considered to possess
incidents of ownership in the policy for purposes of § 2042(2),
provided the decedent could not exercise the powers for the decedent’s
personal benefit, the decedent did not transfer the policy or any
of the consideration for purchasing or maintaining the policy to the
trust from personal assets, and the devolution of the powers to the
decedent was not part of a prearranged plan involving the participation
of decedent.

The ruling further states, however, that the decedent will be
deemed to have incidents of ownership over an insurance policy on
the decedent’s life where decedent’s powers are held in
a fiduciary capacity and the decedent has transferred the policy or
any of the consideration for purchasing and maintaining the policy
to the trust. Also, where the decedent’s powers could have
been exercised for decedent’s benefit, they will constitute
incidents of ownership in the policy, without regard to how those
powers were acquired and without consideration of whether the decedent
transferred property to the trust. Thus, in such a situation, if
the decedent reacquires powers over insurance policies in an individual
capacity, the powers will constitute incidents of ownership even though
the decedent is a transferee. SeeEstate of Fruehauf v. Commissioner, 427 F.2d 80 (6th Cir.
1970); Estate of Skifter v. Commissioner, 468
F. 2d 699 (2d Cir. 1972).

In Estate of Jordahl v. Commissioner, 65
T.C. 92 (1975), acq. in result, 1977-2 C.B. 1,
the decedent created an inter vivos trust. The corpus of the trust included insurance policies on the
decedent’s life and other income producing assets. Under the
terms of the trust, the decedent reserved the power to substitute
other securities or property for those held in trust, provided the
substituted property was equal in value to the property replaced.
After the decedent’s death, the Service argued that the trust
assets were includible in the decedent’s gross estate under
§ 2038 because the decedent’s power to substitute
assets of equal value could be exercised to alter the beneficial interests
in the trust. The Service also argued that the proceeds from the
insurance policies should also be included under § 2042(2)
because the power to substitute the insurance policies allowed the
decedent to reacquire full ownership of the policies in the trust.

The Tax Court determined that, because the decedent was bound
by fiduciary standards and was therefore accountable in equity to
the succeeding income beneficiary and remaindermen, the decedent could
not exercise the power to deplete the trust or to shift trust benefits
among the beneficiaries. Accordingly, the Court held that the substitution
power was not a power to alter, amend, or revoke the trust within
the meaning of § 2038. The court further concluded that
the decedent’s power to substitute an insurance policy was merely
a power to exchange at arm’s length. The Court held that such
a power was in effect a right to purchase the policy and that such
a right could not be considered an incident of ownership.

In Rev. Rul. 2008-22, 2008-16 I.R.B. 796, the grantor created
an irrevocable inter vivos trust for the benefit
of the grantor’s descendants. The grantor retained the power,
exercisable in a nonfiduciary capacity, to acquire any property held
in the trust by substituting other property of equivalent value.
The ruling concludes that the grantor’s retained power to substitute
assets of equivalent value will not, by itself, cause the value of
the trust corpus to be includible in the grantor’s gross estate
under § 2036 or 2038, provided the trustee has a fiduciary
obligation (under local law or the trust instrument) to ensure the
grantor’s compliance with the terms of this power by satisfying
itself that the properties acquired and substituted by the grantor
are in fact of equivalent value. The ruling further provides that
the substitution power cannot be exercised in a manner that would
cause the shifting of benefits among the trust beneficiaries.

In the instant case, like the situation presented in Rev. Rul.
2008-22, the trust instrument expressly prohibits D from serving as trustee and states that D’s
power to substitute assets of equivalent value is held in a nonfiduciary
capacity. However, under the terms of Trust, the assets that D may transfer into Trust must be equivalent in value
to the insurance policies that D will receive.
In addition, T has a fiduciary obligation to
ensure that the assets substituted are of equivalent value. Thus, D cannot exercise the power to substitute assets in a
manner that will reduce the value of the trust corpus or increase D’s net worth. Further, in view of T’s ability to reinvest the assets and T’s duty of impartiality to the trust beneficiaries, there will
be no shifting of benefits between or among the beneficiaries that
could otherwise result from a substitution of property by D. Under these circumstances, D’s
retained power to substitute assets of equivalent value for a life
insurance policy held by Trust is not, by itself, an incident of ownership
under § 2042(2).

HOLDING

A grantor’s retention of the power, exercisable in a nonfiduciary
capacity, to acquire an insurance policy held in trust by substituting
other assets of equivalent value will not, by itself, cause the value
of the insurance policy to be includible in the grantor’s gross
estate under § 2042, provided the trustee has a fiduciary
obligation (under local law or the trust instrument) to ensure the
grantor’s compliance with the terms of this power by satisfying
itself that the properties acquired and substituted by the grantor
are in fact of equivalent value, and further provided that the substitution
power cannot be exercised in a manner that can shift benefits among
the trust beneficiaries. A substitution power cannot be exercised
in a manner that can shift benefits if: (a) the trustee has both
the power (under local law or the trust instrument) to reinvest the
trust corpus and a duty of impartiality with respect to the trust
beneficiaries; or (b) the nature of the trust’s investments
or the level of income produced by any or all of the trust’s
investments does not impact the respective interests of the beneficiaries,
such as when the trust is administered as a unitrust (under local
law or the trust instrument) or when distributions from the trust
are limited to discretionary distributions of principal and income.

DRAFTING INFORMATION

The principal author of this revenue ruling is Mayer Samuels
of the Office of the Associate Chief Counsel (Passthroughs and Special
Industries). For further information regarding this revenue ruling,
contact Mr. Samuels at (202) 622-3090 (not a toll-free call).